Why Do Large Positive Non-GAAP Earnings Adjustments Predict Abnormally High CEO Pay?

For almost two decades, regulators, academics, and investor activists have attempted to understand the role of non-GAAP earnings, also commonly labeled “adjusted” or “pro forma” earnings. About two-thirds of S&P 500 firms announce non-GAAP earnings, which are significantly larger than GAAP earnings on average. Moreover, many of these same companies use non-GAAP earnings as a key criterion in setting CEO pay. We hypothesize and find that when non-GAAP earnings are large relative to GAAP earnings, CEO pay is abnormally high.

Our results are consistent with the managerial power framework of Bebchuk, Fried, and Walker (2002). In their model, all executives have at least some power to extract rents whenever the company lacks a controlling or dominant shareholder to provide discipline. However, outraged boards and dispersed shareholders who recognize rent extraction can impose some constraints. As a result, managers have an incentive to “obscure and legitimize – or, more generally, to camouflage – their extraction of rents.” In this study, we argue that non-GAAP earnings are one mechanism through which some managers limit outrage by camouflaging rent extraction.

Managers routinely claim that non-GAAP adjustments remove transient items in GAAP earnings and are thus more informative about their core, or ongoing, economic performance.  Moreover, large sample evidence suggests that some items excluded from non-GAAP earnings are indeed transient, which helps justify managers’ claim. However, other non-GAAP exclusions are persistent, suggesting some managers exclude losses and expenses not to inform but to increase investors’ perceptions of core operating earnings by reporting “everything but bad stuff” (Turner 2000). Of course, higher perceived firm performance among outsiders likely leads to less outrage about high CEO pay. Ironically then, the seemingly appropriate use of non-GAAP adjustments by some firms actually serves to provide cover for (or “camouflage”) the use of non-GAAP earnings to extract rents by other firms.

Crucially, the key elements of the Bebchuk et al. (2002) model vary across firms, i.e., some managers have more power than others, some compensation arrangements cause more outrage than others, and some rents are easier for investors to identify (or alternatively, for managers to camouflage) than others. This variation leads to a testable prediction that camouflage will be more prevalent when high executive pay is likely to cause more outrage. Consistent with this prediction, we find that the firms with large positive non-GAAP adjustments and excessive CEO pay exhibit worse GAAP earnings and stock price performance than other firms. Also, the excessive pay due to non-GAAP adjustments appears greatest when the CEO is relatively less influential. Naturally, high pay in both of these scenarios, poor performance and a less powerful CEO, is likely to generate pushback from investors. Thus, it appears that CEOs in these situations try to justify their performance and pay using the broadly accepted economic arguments underlying non-GAAP adjustments (i.e., that they remove transient earnings items). Moreover, their non-GAAP adjustments appear to be successful in providing camouflage that limits outrage. That is, we find that such firms are more likely to beat earnings targets and face no special scrutiny from investors, proxy advisors, and the media.

Previous attention to non-GAAP earnings has primarily focused on two issues relating to their use in firms’ earnings releases. First, regulators express concern that non-GAAP earnings might mislead investors and result in mispriced securities. Second, managers claim non-GAAP earnings communicate their firms’ “core” earnings. Our paper sheds light on an additional (but not mutually exclusive) rationale for firms’ use of non-GAAP earnings in a contracting, or “stewardship,” context: to justify high compensation.

Our results raise the question of why do boards allow or participate in this CEO rent extraction? We again rely on the Bebchuk et al. (2002) theory, which suggests three possibilities (see their p. 2): directors may be captured by management, directors may be sympathetic to managers, or directors may simply be ineffectual in overseeing compensation. Unfortunately, despite several conversations with board members about non-GAAP measures, we lack clear evidence on the extent to which the board fills the above three roles. In other words, it remains unclear whether the boards at firms that seem to camouflage their pay actively participate in fooling investors or whether they are, themselves, being fooled by managers.

Logically, the next question this discussion raises is why don’t shareholders (or intermediaries, such as proxy advisory firms or the media) monitor the boards? There is a voluminous literature, which we do not revisit, on the factors governing the (in)effectiveness of shareholder monitoring. Suffice to say that, despite shareholders’ advisory votes on compensation committee reports, there is uncertainty about whether GAAP or non-GAAP earnings better reflect the underlying economics of many firms. This uncertainty is evident in the voluminous, and often conflicting, accounting literature examining whether non-GAAP earnings inform the market, on average. Bebchuk et al. (2002) emphasize how such uncertainty, coupled with diffuse ownership, helps “camouflage” excessive compensation and thus diminishes the effectiveness of shareholder monitoring of boards’ compensation decisions. Our finding that firms with large positive non-GAAP adjustments do not face greater scrutiny from shareholders, proxy advisors, or the media is consistent with non-GAAP earnings providing such camouflage.

While our study highlights apparent opportunistic use of non-GAAP earnings for CEO pay, we are mindful in not overstating the evidence. Depending on whether we analyze total pay or its separate components (i.e., bonus and equity), our estimates of abnormal pay range from 5% to 20% of total pay (i.e., between approximately $600K and $2,400K, on average). Also, we only find abnormal pay among a subset of S&P 500 CEOs. For instance, firms with small positive (or negative) non-GAAP adjustments do not appear to pay their CEOs excessively, even though this mechanism is also available to them. They may instead use non-GAAP adjustments to exclude transient items in order to achieve the benefits of optimal contracting (e.g., measure only costs the CEO incurred) or optimal disclosure (e.g., lower information asymmetry and cost of capital). Additionally, they may be able to achieve high pay without using non-GAAP adjustments, either because their better performance justifies high pay without opportunism or their CEO is powerful enough to achieve high pay through less camouflaged means. Together, our findings imply that only some CEO pay is a result of managerial opportunism, while the majority is likely to be a reward for skill and performance.

Despite these caveats, it appears likely that an economically meaningful fraction of boards and CEOs, especially those in firms with relatively weak performance, are engaging in an opportunistic use of non-GAAP earnings to justify higher pay. Said differently, legitimizing high CEO pay appears to be one of the potentially important reasons for firms to use non-GAAP earnings in contracting.

The complete paper is available for download here.